Basel III, Resolution, Bail-in, Bailout, Ring-fencing, and Banking Union: What Does the Future Hold for Banks and Their Investors?

One could be tempted to feel sorry for banks, especially European banks. The lack of clarity in regulation has never been worse, and some of the most invasive regulation is still to come. Yet banks soldier on, trying to defend their old way of life and hoping that regulators will leave some stones unturned.

After the financial crisis, the general public and politicians have been looking for scapegoats and ways to “fix” the problems and avoid a recurrence of a financial meltdown.

Are they close to accomplishing their goal? Is the regulation wave likely to prevent another crisis? Can they restore trust in a banking system that is viewed as starving the economy of credit, mis-selling products to the public, and taking excessive risks to feed oversized bonuses? Most of these questions will probably remain unanswered for some time, and some may be answered negatively eventually. But investors will soon have to determine what all the regulatory changes mean for the valuation of bank bonds and stocks — a crucial question that may change their appetite, raise further funding costs and possibly have a negative impact on the real economy.

There are already a lot of regulatory proposals under discussion at the EU and national levels. Some proposals are specific to Europe, and some originated in the U.S. (e.g., the proposals on separation of bank functions, such as the Volcker Rule) but were eagerly imported into Europe. Some proposals are important but highly technical, and almost overlooked by politicians and the press, while others are highly political and regularly make the front page of the newspapers.

I will not attempt to discuss Basel III or capital requirements regulation in detail, as the particulars are mind-boggling. Agreement from legislators in Brussels is imminent; however, discussions are still ongoing on limits to bankers’ remuneration. It might be an improvement over Basel II, but critics already complain that Basel III can be “gamed” just as current regulation was. Furthermore, there is uncertainty about the timing of Basel III’s implementation in the U.S.

Bank Resolution and Bail-In Bonds

A very important legislative proposal is making its way through the European Parliament and the European Council. The directive proposal, “a framework for the recovery and resolution of credit institutions and investment firms,” aims to harmonize the powers of national regulators to step in when a bank is in trouble, create a special insolvency regime for banks, and impose “bail-in” debt to avoid or reduce the need to use taxpayers’ money to bail out banks. On one hand, this regulation simply aims to ensure that a resolution regime and authority is in place in every Member State of the EU, and that a minimum level of coherence exists among resolution frameworks. This will be helpful in harmonizing recovery and resolution action, and give more certainty to investors. At the same time, the introduction of bail-in debt clearly shows politicians’ willingness to shield taxpayers from bailout costs and widen the circle of investors who would suffer in case of bank failures.

The European Commission proposal would give resolution authorities the power to write down the claims of unsecured creditors of a failing bank and to convert debt claims into equity. Some liabilities would be excluded (e.g., secured liabilities, covered deposits and liabilities with a residual maturity of less than one month), but, crucially, the proposal would set minimum amounts of bail-in debt required for the balance sheet of each bank, which would be proportionate to the riskiness of the bank or the composition of its sources of funding — the European Commission mentions 10% of total liabilities as a possible level in the explanatory memorandum accompanying the directive. The European Commission even envisages cases where resolution authorities could use the “bail-in tool” and write down debt instruments without having exhausted shareholders’ claims.

This is a radical departure from the bailouts during the financial crisis, where only shareholders were wiped out. Some countries, such as Spain and the Netherlands, are anticipating EU resolution regulation. In the bailout of its savings banks (or cajas) in 2012, Spain decided to inflict losses also on preferred shareholders and unsecured bondholders, including many retail investors. In the recent nationalization of SNS REAAL in the Netherlands, unsecured bondholders were wiped out together with shareholders.

Getting bondholders to pay up may be popular with those individuals who are tired of the mutualization of bank losses, but it has fueled a discussion on how widely the pain of bank failures should be spread, in light of their systemic impact. Is it fair to impose losses on retail investors, who may have bought bank bonds thinking they were safe investments? Spain is considering ways to compensate retail investors, showing that burden sharing is a double-edged sword — unless the riskiness of unsecured bank bonds is re-evaluated and products are correctly marketed.

When the new resolution regulation is in place and bail-in bonds are required, investors will need to take into account the higher risk and increased cost of capital. Unfortunately, in order to make an accurate assessment of the value of bank bonds and equity, more details on the upcoming regulation are needed. The European Commission proposal is still being modified, and detailed implementing measures are yet to be drafted, so uncertainty will continue for quite some time.

Banking Union

A separate legislative initiative born out of the eurozone crisis is the banking union, which foresees proposals for a Single Supervisory Mechanism (SSM), a single resolution authority, and also potentially a common deposit guarantee scheme. While the heads of state in the EU agreed on an SSM in December, the next two crucial steps to establishing a banking union are still uncertain. A complete banking union would considerably weaken the link between banks and their governments if it implied the mutualization of costs to bail out banks among all the members of the banking union — in case a national deposit guarantee scheme did not have enough funds to reimburse depositors. This would be highly beneficial for the banks (and their ratings) in highly indebted countries of the eurozone but negative for banks in stronger countries with well-funded guarantee schemes — hence the lack of political agreement so far on further steps.

Ring-fencing Retail Banking

The last crucial banking reform is about ring-fencing of retail and commercial banking. Following the Volcker Rule proposals in the U.S., a heated discussion has also started in Europe on the best recipe to protect retail banking by ring-fencing it from riskier investment banking activities — particularly proprietary trading, but also exposure to hedge funds, private equity, etc. The idea is to find a way to insulate retail banking (and some parts of commercial banking, depending on the version) from other activities so that only this part of the business would benefit from public support and bailout, while the other parts of the bank would be allowed to fail.

Given the preponderance of the universal banking model in Europe and its benefits for bank funding, it is understandable that banks are desperate to avoid it. Against the alleged benefits (elimination of moral hazard and preservation of taxpayer money), banks point to the risks embedded in retail banking (real estate lending), the cross-subsidies to retail and commercial clients, and the inevitable harm to the real economy as a result.

It seems inevitable that this reform would also raise capital requirements and costs for banks, but much would depend on the exact form: although full separation is not proposed in Europe, what would be ring-fenced and what would be allowed? How much capital would have to be set aside for each part of the business, etc.? As usual, there are many national flavors to these reform plans, and the European Commission is now tasked with making proposals following the report of the European Commission’s High-level Expert Group on bank structural reform, known as the Liikanen Group. It will not be an easy task, as some EU Member States are much more advanced than the EU. France and Germany already have draft laws, and the U.K. has already received recommendations from the Independent Commission on Banking in the Vickers Report, which should soon be implemented in legislative proposals.

All of the aforementioned initiatives are important pieces of a regulatory puzzle that is supposed to protect the economy and the public from another crisis. Each of these initiatives could be helpful, unless the side effects for the real economy are as severe as bankers predict.

So what banks will emerge from the regulatory binge? Will it be boring utilities with high capital requirements or risky investment banks? What about hybrid entities with regulators ready to intervene quickly to protect retail activities and abandon the rest to insolvency (assuming governments would really abandon large investment banks to their destiny)? What ROE can one expect from banks in the future when all loopholes have been closed and leverage is reduced? Furthermore, which banks will enjoy the most favorable regulation in the rather uncoordinated race to regulate across jurisdictions?

Whatever the outcome, it will be a different banking world, and analysts and investors will need to learn the new rules of the game.